Explaining Credit Scores
Your credit score is the magic number that makes or breaks your application for a car loan, a mortgage or a new credit card. More importantly a credit score determines how much each of those lines of credit is going to cost. Generally speaking, the higher your credit score, the lower your interest rate and the less you pay to borrow.
But understanding a credit score means more than knowing credit scores range from 300 to 850, that scores above 750 are great and scores below 650 are not so great. Knowing how to access your credit score is just the first step: you also need to know how to report inaccurate information, monitor changes in your score and what steps you can take to improve your score.
[Note: Work + Money receives a commission from our affiliate partners via our links, but our reporting and recommendations are independent and objective.]
Credit Score Basics
What is a credit score?
A credit score is an attempt to measure how good you are when it comes to paying bills. First developed by the Fair Isaac Corporation, credit scores offered by the major credit bureaus try to assess and track how you borrow and repay money. A FICO score is the same thing as a credit score: it’s just the brand name of the one provided by Fair Isaac.
These days, FICO licenses its formula to Experian, EquiFax and TransUnion, who pull financial information from a slightly different network of lenders. As a result, your score can vary by as much as 50 points between the three major credit bureaus.
How Do I Find Out What My Credit Score Is?
You're entitled to one free credit report per year from each of three bureaus. You can also select services to monitor your credit and send you reports at more regular intervals.
For instance, you can pick up a free credit report card from Credit Sesame, here.
How Valuable Is A Good Credit Score?
Remember, the higher your credit score, the lower your interest rate on a wide range of lending products. Let's take Tricia Trustworthy and her credit score of 765, which is excellent, and Michael Middleman, whose credit score of 687 happens to match the average U.S. credit score.
Tricia's gets offered a 4.981% rate on her home loan application for a $166,850 mortgage, while Michael gets offered a rate of 5.38%. Over the life of the loan, the mortgage costs Tricia a total of $326,900, while Michael pays $341,689, or nearly $15,000 more than Tricia.
The same math comes into play when each applies for financing on a new, $25,000 car. Tricia's 6.42% rate means she pays $29,487 for the car over the life of the loan, while Michael's 9.86% rate results in him paying $31,724 for the same car. And keep in mind, Michael's credit score is average: people with lower scores will pay even more. If your credit score is below 620, you'll have trouble getting a home loan. If it's below 500, you are unlikely to qualify for even a high-interest car loan.
Check More Than The Scores
Knowing your score is a start, but you need to carefully read the report that comes with it. Credit reporting bureaus are known for making mistakes, so check your report for errors and immediately report it to the offending credit bureau. They have 30 days to investigate the error and respond to your inquiry.
Mistakes happen often. One study found errors in 79% of credit reports, with one in four of those errors being significant enough to lower a credit score. They also happen for a variety of reasons. The credit bureau, for example, may put information from someone with a similar name on your report. Make sure you check for accounts you have never opened, addresses you have never lived at, a wrong date of birth or Social Security number and an inaccurate reporting of delinquencies.
Your Credit Report As An Identity Theft Defense
Checking your credit report for inaccuracies on a regular basis has an added bonus: those checks for inaccuracies not only find errors, but help identify instances where your identity is stolen. A lot of those services that costs hundreds of dollars per year are simply looking for changes in your credit report that suggest your identity has been stolen. You can accomplish the same task for free by making regular checks of your credit reports.
If you do find that your identity has been stolen, you want to contact the credit bureaus as well the company or companies the thief used to set up accounts under your name. Filing a report with your local police department is also a good idea, as it establishes that you were proactive in addressing the crime.
How Late Payments Affect Your Credit Score
Your FICO score puts different weights on different credit events, and one of the biggest is your history of paying bills on time. Being 30, 60 or 90 days late on a payment has a huge impact on your credit score, and those black marks can linger on your credit report for up to seven years. Your payment history accounts for as much as 35% of your FICO score, so making sure you pay bills on time is the best way to keep your credit score above 750.
Look for credit cards that forgive a late payment for that one time your check gets lost in the mail. Better yet, set up autopay through your bank's online banking portal, or use a service like Mint.com to send you reminders when bills are due so you never make a late payment. Establishing a track record of paying all your bills on time, even if you just pay the minimum amount due, is one of the best ways you can start to move your credit score up.
The Second Big Factor: Credit Usage
The second, heavily weighted criteria on your credit score is how much of your available credit you use. At 30%, this factor is only slightly less important than your payment history. If you max out your credit cards and keep stretching out loan terms with refinancing but don't pay down the principle, your credit score will reflect this.
Creditors generally want to see you keep credit usage under 30%. In other words, if you have a credit line of $1,000, you don't want to use more than $300 of it. And people with the highest credit scores usually have debt utilization levels below 10%. Experts warn to never let your total credit usage rise above 50% unless you want your credit score to take a dramatic drop.
One way to keep your credit usage low is to split your monthly payments into two. By paying twice a month, you're factoring for automatic charges on your credit card and finance charges that are automatically applied and may push you above the threshold that concerns lenders.
Keep in mind this portion of your credit score doesn’t measure your total debt, but the percentage of debt you are using. If you have $250 on four credit cards with credit limits of $1,000 each, you may think transferring all of the balances to a single card and closing the other three accounts is a sound financial move. But in reality, you've gone from using 25% of your available credit to 100% of your available credit, which will negatively impact your credit score even though you have not increased your total amount of debt.
Don't Close Your Old Accounts
Somewhat counterintuitively, closing an account can negatively impact your credit score. Even if you have paid off a balance and have no intention of using the credit card, keep it open. It will help you stay below the credit usage threshold and won’t put a red flag on your credit report for a closed account. As a result, you want to look for credit card accounts that don't charge an annual fee. If you're worried you'll be tempted to use those lines of credit, destroy the card associated with the account as soon as it arrives in the mail. The account will remain open even if you don't use it.
The reason for keeping accounts open is that a FICO score, more than anything else, is measuring your credit history. The average length of all accounts you have accounts for about 15% of your credit score. Accounts that you have kept open for a long time and have consistently paid off are more valuable in boosting your credit score than newer accounts. And closing an account is scored adversely in scoring your credit. Similarly, a late payment on an account you just opened hurts a lot more than a late payment on an account you've had for 10 years.
Also keep in mind that you need to occasionally use your credit cards, or you risk the lender closing the account for inactivity. If you have paid off a credit card and want to keep the balance zero, make regular, small charges every few months that you can pay off before incurring interest. A gym membership, for example, is a predictable expense that you would have been making anyways: have the automatic monthly payment go to your credit card, then pay off the credit card each month to keep the balance at zero.
How To Get Around The Multiple Inquiry Clause
Opening or even applying for new lines of credit negatively impacts your credit score, so you want to keep these inquiries to a minimum. In addition to making new debt more expensive, many banks and credit cards now regularly check the credit reports of their existing customers and have provisions that allow them raise your interest rates if they see your credit score dropping.
Still, life happens: people need to apply for mortgages, student loans, and auto financing. If possible, plan ahead for your credit inquiries and try to keep every new application within the same 45-day window. This will be reflected as a single inquiry on your credit report and not drag down your score as much as if you had applied for three new lines of credit over a six-month period.
New credit inquiries and new credit accounts are weighted at 10% of your credit score. Keep in mind, applying for new credit is a so-called "hard" inquiry. Soft inquiries, like checking your credit score or those pre-approved offers that flood your mailbox don't negatively impact your credit score.
Not All Credit Is Created Equal
Mortgages, car loans and student loans are installment loans with consistent, monthly payments, which makes it easier to predict your debt management habits. Credit cards are "revolving" loans and what you owe can fluctuate wildly from month to month. As you can probably guess, a credit score is more forgiving to installment loans than revolving loans.
What creditors are really looking for is a healthy mix of this good and bad debt. You can have as many as four or five credit cards providing you don't exceed acceptable credit thresholds, but beyond that, you risk throwing your debt off balance.
Likewise, not having enough "good debt" can be a concern. Even if you're the type of person who pays cash for major purchases like a new car, you may want to look for a low- or zero-percent auto loan to pay for a portion of the car. As long as the interest rate doesn’t exceed inflation, you won't lose money and you'll have the added benefit of a healthy credit mix.
Only You Can Improve Your Credit Score
There are a lot of companies out there that will offer to improve your credit score – for a fee, of course. One common come-on are "dispute mills" which claim to raise your score by fighting to remove negative items from your credit report. What these companies do is dispute items on your credit report and the credit bureaus need to remove them from your credit report for the 30-day period they have to investigate the disputed item.
The problem is, if that derogatory report was legitimate, it will come back onto your report after the 30-day window closes and the lender reports again to the bureau. The reality is it's cheaper and easier for you to dispute legitimate inaccuracies on your own. And the only real cure for an ailing score is using credit responsibly over time.
Start Small, Start Soon
Unfortunately, there's no quick-fix way to boost a bad credit score to average and an average credit score to great. It takes time, and with some of those negative events lingering on credit reports for up to seven years, the longer you wait to get started, the longer it will take to improve your score.
First and most importantly, you need to do whatever it takes to make sure you pay every bill on time. From there, you need to attack your debt: start with small "nuisance" balances since one measure of your credit worthiness is how many accounts you have where you carry a balance. Attacking the small balances first will improve this portion of your credit score.
Then attack the bigger balances, starting with the balances with the highest interest rates. Commit to paying off your debt: don't just settle for moving debt from one account to another, as that trick shows up on your credit report.
Set realistic goals for how much debt you can pay off each month: one red flag is when you suddenly miss a payment or pay less than you had been. Similarly, if you suddenly charge more than usually, that will raise a red flag in your credit report (Note that you can get a free credit report card from Credit Sesame, here).
Make sure you regularly check your credit reports. Set reminders on your calendar to check one report from one of the three bureaus every four months. Because there's overlap between the three bureaus, that will allow you to catch any big discrepancies and instances of identity theft. And remember to keep that old debt on your credit report: getting that old car loan taken off your report because it's paid off actually hurts your score, especially if you made your payments on time.